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Stock Market Bubbles

News

A Theory Explaining Stock Market Bubbles

Evan Cooper Jan 31, 2017


What if one of the cornerstones of modern finance, the efficient market theory, was sort of right instead of totally correct?

The theory maintains that the current price of a stock always incorporates and reflects all relevant information, meaning that a stock’s price is rational and its true value. Logically, that leads to the conclusion that there can’t be undervalued or overvalued stocks. And if that’s the case, then trying to beat the market through active management is a fool’s errand, fundamental and technical analyses are wastes of time, and passive, index-based investing is the only approach that makes sense.

The Historical Record

On the other hand, history shows that there were more than a few times when the market was either vastly overvalued with investors way too exuberant (such as before The Crash of 1929 or during the dot-com bubble), or a screaming buy because investors were unnecessarily gloomy, such as in the 1940s when they feared another depression.

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